Regular Investing – A great way to build wealth over time
A regular savings plan is a great way to build wealth over time. By saving regularly and earning interest on your savings, even the smallest amounts can grow substantially. By investing an amount each month, you will be well on your way to developing substantial savings, and this introduces you to the world of investing. Regular savings plans enable you to invest your surplus income (the minimum amount is usually $100 per month) while allowing you to access your funds if required.
What are the benefits of regular savings?
A regular savings plan over the long-term will help smooth out your purchase price of those investments through the market ups and downs, thereby reducing the risk of investing in volatile markets. Please refer to the Dollar Cost Averaging fact sheet under the Key Investment Concepts Financial Education Series. By re-investing the income, your investment benefits from the effect of compound growth, which is the distribution from your investment earning interest. You have the flexibility to access your funds with the ability to vary or suspend contributions (depending on the account set-up). You may be surprised at how quickly you are able to build up a reasonable amount. If you are able to save $100 per week that adds up to over $5,000 by the end of the year.
Capital Protected Lending
Capital protected lending products are investments guaranteeing that you will receive your original investment amount back at maturity. If the market goes up you will receive any gain on the investment, but if the market goes down you will still receive your original investment back, you will not be liable for the loss. It is important to note that the majority of capital protected products are only protected at maturity. That means that if you exit the product before the maturity date you may realise a loss, and you may also be liable for break costs or exit fees. An additional risk with a capital protected product is that you may still make an overall loss on the investment, because of the fixed investment period. If the asset decreases in value, you will still receive your original capital back at maturity but you may have to pay the annual interest cost for the remainder of the term. As such you may still make a loss from the strategy. A final point to note is that you will pay a higher cost for the capital protection. In other words, if you invested in a capital protected product versus the same product without the capital protection, it would cost you more to invest in the capital protected product.
How does Capital Protection work?
There are a number of different methods of capital protection, and each works differently and varies in cost. The most common are:
- Put options
- Zero coupon plus call
- Constant proportion portfolio insurance (CPPI) also known as threshold management
As the method used will differ depending upon the product you should discuss this with your financial adviser before making an investment.
Andrew invests $100,000 into a 7-year capital protected product. At the end of year 7 the investment is worth $180,000. Andrew gets to keep the full $180,000 but may be liable for tax on the gain of $80,000. Simon invests $100,000 into a different 7-year capital protected product. At the end of year 7 the investment is only worth $95,000. As the product is capital protected Simon will receive his full $100,000 back. He will not incur a loss of $5,000.
Risks of Gearing
While the rewards from gearing can be high, there are also a number of risks that you need to be aware of:
- Gearing can magnify losses: As gearing magnifies the potential return you may receive on your investment, it can also magnify the losses if your investment declines in value.
- Risk of interest rate changes: You need to ensure that you could manage the interest repayments if interest rates were to increase.
- Importance of gearing into growth assets: Gearing costs money. Each year you need to pay the annual interest on the loan. If the investment you have geared into isn’t growing in value then you should reconsider the strategy.
- Risk of loss of cash flow: You should only borrow to invest if you have the financial ability to absorb the effect of potential falls in investment values, the ability to fund margin calls if using margin lending, and/or the increased cost of interest payments. Another risk is that the income from the investment (rent or dividends) may decrease or temporarily cease, which may place a burden on your cash flow.
Before considering a gearing strategy we strongly recommend that you discuss this with an adviser at Acorn Financial Services.
Investment bonds, also called insurance bonds, are long-term, tax-paid investments. Investment bonds can be tax effective for long-term investors with a marginal tax rate higher than 30%, as long as certain rules are followed. They’re also an effective way to put aside money in the name of young children, who are subject to additional taxes on other investments (like interest from savings for example). Most investment bonds offer investment options such as cash, fixed interest, shares, property, infrastructure or a range of diversified investment options, with risk levels ranging from low risk to high risk. The value of the investment bond will rise or fall with the performance of the underlying investments. In order to receive the full benefits of these investments, you will need to hold them for at least 10 years (the 10 year rule) and meet the contributions rules (the 125% rule).
10 year rule
Investment bonds are tax paid investments. This means when earnings on the investment are received by the investment provider, they are taxed at the corporate tax rate (currently 30%) before being reinvested in the bond. The investors do not need to include earnings from insurance bonds in their tax returns unless withdrawals are made in the first 10 years. This can make insurance bonds a tax effective long term investment for those with a marginal tax rate higher than 30%. If you hold the bond for at least 10 years the returns on the entire investment, including additional contributions made, will be tax free subject to the 125% rule. If you make a withdrawal within the first 10 years, the rate at which earnings in the investment bond are taxed will depend on when you make the withdrawal in that time.
|Year withdrawal made
|Withdrawals within 8 years
|100% of the earnings on the investment bond are included in your assessable income and a 30% tax offset applies*.
|Withdrawals in the 9th year
|2/3 of earnings on the investment are included in your assessable income and a 30% tax offset applies*.
|Withdrawals in the 10th year
|1/3 of earnings on the investment are included in your assessable income and a 30% tax offset applies*.
|Withdrawals after the 10th year
|All earnings on the investment are tax-free and do not need to be included in your assessable income.
* The 30% tax offset compensates for the tax already paid on earnings by the investment provider.
Strategic financial advice. Protect, plan and grow.
The 125% rule
Investors in investment bonds can make additional contributions each year, as long as the contribution does not exceed 125% of the previous year's contribution. The investment treats all contributions under 125% as part of the initial investment amount. This means each additional contribution does not need to be invested for the full 10 years to receive the full tax benefits. If contributions are made to the investment bond that exceed 125% of the previous year's investment, the start date of the 10 year period will reset to the start of the investment year in which the excess contributions are made. You will then have to wait a further 10 years from this date to gain the full tax benefits.
Benefits of investment bonds
- Can be a tax effective long-term investment
- Most investment bonds offer a range of investment choices
- Can be an effective way to save for a child's future, given the long-term nature and tax advantages
- Can be used as an estate planning tool.
- May be useful for people who are unable to contribute to superannuation (like those over 65 and not working)
- Subject to meeting the two rules, investments are not normally subject to capital gains tax when redeemed as the tax on realised capital gains is paid by the bond issuer.
Risks of investment bonds
- They can be slower than some investments to convert the balance to cash and some investment bonds have minimum balances that must be maintained.
- If you need to withdraw some of your money before the 10-year period is reached some of the tax benefits will be lost.
- You will pay fees, which can vary widely depending on the issuer of the investment bond and the investment options chosen.
Things to consider before investing
If you are considering investing in an investment bond here are some things to think about:
- Are you in it for the long haul? The full tax benefits from investment bonds are only realised if no withdrawals are made for 10 years and you comply with the 125% rule.
- Are you able to make regular contributions? These investments are particularly tax effective for people who make regular contributions over the life of the investment.
- What investment options are available? It is important to choose a product that offers investment options that are aligned with your risk tolerance and investment goals.
- What are the fees on the investment bond? Common fees you may pay include establishment fees, contribution fees, withdrawal fees, management fees, switching fees and adviser service fees. Shop around and compare the fees to similar products in the market.
- Are you using the product for estate planning purposes? Make sure it fits with your estate planning goals.
Please contact us at Acorn Financial Services for more information regarding investment bonds.